**Item set for 30-March (Equity):**

**Robert Higgs Case Scenario**

Robert Higgs, CFA, is working as a security analyst in Casey Research. His primary job is to calculate the required return on equity for various stocks. He has developed an expertise in this field by working more than five years.

He is looking at S&P Index. He calculates the equity risk premium using macroeconomic model estimates. The data for the security is given in Exhibit 1.

Expected inflation, EINFL |
2.0% |

Expected growth rate in real earnings per share, EGREPS |
2.5% |

Expected growth rate in P/E ratio, EGPE |
5.0% |

Expected income component, EINC |
3.0% |

The expected risk free rate is 6% per annum.

He also calculates the equity risk premium of S&P Index using Gordon growth model estimates. The dividend yield on the index based on year-ahead aggregate forecasted dividends and aggregate market value is 2.5%. The consensus long-term earnings growth rate is 4.5%. The current long-term government bond yield is 3.0%.

Bob Murphy, portfolio manager in Casey Research, asks Robert to calculate the required return on equity for a small cap stock using Fama-French model. Robert extracts the data for the small cap stock, Bluestone Inc., which is given in Exhibit 2.

RMRF (return on market value-weighted equity index in excess of the one-month T-bill rate) |
6.0% |

SMB (average return on small cap portfolios minus the average return on large cap portfolios) |
1.5% |

HML (average return on high book-to-market portfolios minus the average return on low book-to-market portfolios) |
3.0% |

Beta (market) |
1.2 |

Beta (value) |
-0.7 |

Beta size |
0.9 |

Risk-free rate |
6.0% |

Bob inquires Robert about the model to be used for calculating the required return on equity for relatively illiquid securities. Robert replies that a model known as Pastor-Stambaugh model (PSM) can be used to calculate the required return on equity. The liquidity premium is also added to Fama-French model and the beta of the stock with respect to liquidity is multiplied with the liquidity premium to get the liquidity premium for the stock. He also makes following statements:

Statement 1: The more liquid stock will have a higher liquidity beta

Statement 2: Average-liquidity equity should have a liquidity beta of zero

Statement 3: The liquidity premium represents the excess returns to a portfolio that invests the proceeds from shorting high-liquidity stocks in a portfolio of low-liquidity stocks

One colleague asks Robert to calculate the required return on an equity using bond yield plus risk premium method for Capstone Inc. The data for Capstone Inc. is given in Exhibit 3.

Macaulay Duration of long-term debt |
12.80 |

Modified duration of long-term debt |
11.95 |

Number of coupon payment per year for long-term debt |
1.0 |

Risk premium for holding the security |
4.5% |

Risk-free rate |
6.0% |

Bob asks him about the difference between the statistical multifactor models and macroeconomic factor models. Robert makes the following statements:

Statement 4: In macroeconomic factor models, the factors are economic variable that have impacted the historical cash flows of companies

Statement 5: In statistical factor models, statistical methods are applied to historical returns to determine portfolios of securities that explain those returns in various senses.

1. What is the equity risk premium for S&P Index? Use macroeconomic model estimates to calculate the equity risk premium.

a) 6.50%

b) 6.78%

c) 7.07%

2. What is the GGM (Gordon growth model) equity risk premium estimate?

a) 3.90%

b) 4.00%

c) 4.11%

3. What is the required return on equity for Bluestone Inc. using Fama-French model?

a) 12.45%

b) 14.85%

c) 16.65%

4. Which of the following statements made by Robert is least likely to be accurate for PSM model?

a) Statement 1

b) Statement 2

c) Statement 3

5. What is the required return on equity for Capstone Inc. using bond yield plus risk premium method?

a) 9.80%

b) 10.50%

c) 11.61%

6. Which of the following statements made by Robert regarding the statistical multifactor model and macroeconomic multifactor model is least accurate?

a) Statement 4

b) Statement 5

c) Both statements are correct

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